Classroom Games: A Market for Lemons

The incentives that arise in markets with asymmetric information are illustrated in the classroom exercise presented here. Student sellers choose both a quality 'grade' and a price for their products. Initially, both prices and grades for all sellers are posted, and buyers select from these offerings. In this full-information setup, the market prices and grades quickly reach efficient levels that maximize total surplus. Next, although sellers continue to choose grades and prices, only prices (not grades) are posted for buyers to see when they shop. The grades and prices then fall to inefficiently low levels. The observed market outcomes in this exercise can stimulate useful discussion of asymmetric information, market failure, and remedies such as quality standards and warranties.